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Fund Focus: UK equity income funds can deliver on yield promises

DariusMcDermot
Darius McDermott: ’I think base rate is going to stay low, so income is a very very big driver for people investing at the moment’

Although the UK equity income sector has fallen slightly from favour in the last couple of years, demand for income means the sector is unlikely to fall too far. The pressure on interest rates for cash deposits looks set to continue and investors are having to address this by seeking income-producing risk investments.

Chelsea Financial Services managing director Darius McDermott says the search for income will remain an investment theme this year. “I think base rate is going to stay low, so income is a very very big driver for people investing at the moment.”

Gary Potter, co-head of Thames River Multi-Capital, also says the search for income is going to be a strong driver of investment sentiment. “Interest rates have stayed lower for longer and the search for income has become essential for many investors. They appear to be increasingly prepared to take some risk to improve the income on their investments.”

With demand for income particularly pressing among people in retirement, Rowley Turton IFA Scott Gallacher says equity income remains a sensible option for pensioners who can take on investment risk, particularly when the dividend income is shielded by an Isa as an alternative to cash.

Gallacher says: “Those prepared to accept investment risk should consider investment into equity income funds (within a stocks and shares Isa). These invest into a range of UK and international companies, and currently yield between 3 and 5 per cent. This would give an initial income better than deposit rates with the prospect of both a rising income and capital growth over the longer term.

“The value of shares may rise and fall but the dividend income from a broad spread of top quality UK and international companies tends to remain fairly stable and has trended upwards over time. Hence, if you focus on the income statements as opposed to the valuation statements, shares look a very sensible investment from an income perspective.”

The outlook for dividends for UK companies looks good. The latest edition of the Capita Registrars Dividend Monitor shows that, with the major exception of BP,

John Chatfeild Roberts
John Chatfeild-Roberts: ’Yields on equities look more attractive in many cases’

individual company dividends were increased by an average 7.5 per cent in 2010 and the company predicts this upward trend to increase this year.

Capita Registrars says it expects total dividends paid in 2011 to rise by 9 per cent from £56.5bn to £59.6bn. This would increase even further if BP resumes paying a dividend.

Chief executive Charles Cryer says: “2010 saw very broad-based recovery in dividends. The vast majority of companies and sectors returned more to shareholders as the need to hoard cash in the face of tight credit and a weak economy receded. Even though share prices have rebounded, the income on equities is still looking very attractive, far ahead of bonds and cash. After a really tough two years, income investors can look forward to a much better year for dividends.”

The lack of alternatives to equity income is a strong reason for the reasonable resilience of UK equity income funds despite disappointing returns over the last two years. With cash returns very low and fears of a bond bubble making the relatively low returns available from bonds less attractive, equity income becomes almost the default option.

Jupiter Asset Management chief investment officer John Chatfeild-Roberts says both corporate and government bonds are starting to lose their attractions for income investors.

He says: “The risks associated with holding these assets are increasing. Government debt looks particularly vulnerable with the yield on US Treasuries blowing out from 2.51 per cent to 3.28 per cent last week on the back of a new stimulus package aimed at boosting US growth and better economic data. This has come on the back of sharp rises in yields this year for debt-ridden eurozone countries such as Greece, Ireland, Portugal and Spain and investors should expect volatility to continue.

“Investment-grade corporate bonds are also looking less attractive. Companies are generally in pretty good shape but their bonds are vulnerable to increases in government bond yields. Opportunities remain further down the credit-rating spectrum but investors need to be very selective and focus on protecting against downside risk.

“Yields on equities look more attractive in many cases and while equity income funds have underperformed growth funds for some time, they may prove a better option for investors seeking income than all but the most flexible of bond funds.”

Property, another traditional income-generating asset,has still to properly recover from the hammering it took in 2007 and 2008 and is some way off from retail investors’ favourite sector.

McDermott believes property has turned a corner and has a place in a long-term-income-generating portfolio but it is not a sector he would consider over the shorter term. “Property is a good income diversifier, no question, but would I want to put £1 into commercial property today over a two to three-year view? Possibly not.”

One possible rival are the increasing number of overseas equity income funds. McDermott says his firm added two overseas equity income funds, a global fund and an Asia income fund, in the last 18 months to get away from the concentration of UK dividend-paying companies and retail interest has been strong in these areas.

He says: “The M&G global dividend fund is approaching £1bn and that is less than three years old, so that is a pretty good strike rate for raising money.”

Hargreaves Lansdown senior investment manager Ben Yearsley says HL is also seeing increasing interest in overseas equity income funds.

He says: “Investors are buying them, they are buying Europe, they are buying global, they are buying Japan but not in huge numbers because there is not much choice.”

Yearsley says retail fund inflows to equity income is still predominantly into UK funds but this is “only because there is such a lot of choice there”.

But with four separate overseas equity funds launched in the first four weeks of 2011 the choice of alternative to the staple UK equity income fund is broadening all the time.

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